The central plank of the coalition’s welfare reform programme is finally being rolled out. By merging several major benefits and tax credits into one payment – the new universal credit – work and pensions secretary Iain Duncan Smith hopes people will now always be better off in work than on benefits. The road towards the new system will be bumpy, of course. The first pilot has barely begun, and IT problems are already appearing. But in hindsight, these will merely be seen as teething troubles. So what will the impact of the new system be once it is fully established?

On the positive side, the universal credit will improve one of the welfare system’s major flaws – its mind-boggling complexity. The current system comprises a host of income transfers, most of which can again be subdivided into countless elements and optional add-ons. Many of these transfers serve similar purposes, so it’s unclear what all this administrative duplication is good for. The job of a benefit adviser has become similar to the job of a tax adviser, requiring familiarity with guidebooks running into thousands of pages.

But the problem with this arrangement is not administrative; it is the poverty traps it produces. Since each transfer has a different withdrawal rate and uses a different means of assessing eligibility, and since withdrawal rates interact with each other in different ways, it can be a challenge to work out how a change in gross earnings would translate into a change in net income. For someone who receives more than one benefit, it’s unclear whether taking on an extra day of work would leave him or her better off. By merging six major transfers into one, the universal credit will bring clarity and predictability, as it leaves one single withdrawal rate of 65 per cent of net income.

Secondly, the current system’s complexity makes the transition in and out of work harder. Imagine you receive out-of-work benefits and are offered a job for an uncertain period of time. Once you take the job, you may lose your out-of-work benefits. But if it turns out that the job does not last, you will have to re-apply for them all over again. Taking a job becomes a gamble, as it replaces a certain income source with an uncertain one. The universal credit, being both an in-work and an out-of-work benefit, will make this transition a lot smoother. It adjusts flexibly to your earnings level, without lengthy multiple application processes.

So far so good. Universal credit will help those who are able and willing to work, but who are currently trapped in the net of the welfare bureaucracy. Yet other flaws remain unresolved, or are even worsened. Work incentives at the margin will remain feeble, for instance. The combination of income tax, national insurance and the withdrawal of universal credit will create an implicit marginal tax rate of 76 per cent – well above the top marginal income tax rate. The groups with the weakest attachment to the labour market will continue to face the weakest work incentives.

This is related to another absurdity in the current system. We like to think of taxpayers and benefit recipients as distinct groups, but they are often the same people. A large part of the current system is simply redistribution from the right-hand pocket to the left-hand pocket. Why not just leave low-earners more of what they earn, and eliminate the corresponding chunks of tax and welfare administration? This could be achieved by integrating the universal credit into the tax system, thus turning it into a “negative income tax”.

Positively, universal credit will encourage more workless people to get on the first rung of the job ladder – by trying minor employment, for example. But it provides little incentive to move on from there. This is already a feature of the current working tax credit (WTC), but the universal credit will exacerbate it. Receipt of WTC is conditional on a minimum number of hours worked (which differs between households), while the universal credit contains no such provision. In theory, it will be possible for a recipient to settle permanently into a one-day workweek, with universal credit making up the salary shortfall. The credit should, instead, come with a requirement to increase working hours over time, towards a workload not too far below full-time employment. It should be a wage supplement, not a permanent wage substitute.

On balance, universal credit is clearly a change for the better, and Duncan Smith may be right when he calls it “the start of a fundamental cultural shift of the welfare system”. But only if the emphasis is on “the start”.

Read the original article in City AM.

In November 2010 the IEA published Transforming welfare – incentives, localisation and non-discrimination. This paper called for replacing the complex benefit and tax credit system with a negative income tax to dramatically simplify the way welfare is delivered.